Following the ongoing earnings driven rally that occurred during the first three weeks of November that we had been expecting, the equity markets have run into a formidable three-pronged headwind — being tactically overbought, the announcement and global “panic” regarding the Omicron COVID variant, and hawkish comments from Fed Chairman Powell. As has been the case for much of the last 21-months since the S&P 500 price low during March 2020, the emergence of negative headline news has energized the bears. So, is it time for an investor to become defensive or is this another opportunity to use extreme market action to one’s benefit? I will delve into what my research is signaling in this month’s FSI sector allocation update.

Before I do, let me remind readers what the goals are:

• Outpace the S&P500 by actively managing the 11 S&P 500 Sector SPDRs, but also taking on less risk.
• We are not looking to be super aggressive tactical traders trying to pick every tiny wiggle in relative sector performance.
• With this being said, we normally have a 6-9 month view, at minimum, try to keep turnover on the lower side, and to beat the S&P 500 by having high Sharpe Ratio and Information ratios (i.e., risk adjusted returns).

Throughout much of 2021, we have frequently commented about the equity markets climbing the Wall of Worry. Interestingly, the Wall is still present, but the individual bricks have been changing over time. The existence of negative headlines and worrying events do not always lead to weakness for stock prices and that can be challenging for any investor to process and not submit to their emotions. Indeed, when new information is introduced, we always need consider its implications, but it is not necessarily an automatic become bearish signal. Our historical research suggests the strength of a profit cycle, the earnings revisions trend as measured by our proprietary indicators, and monetary policy can often offset and even overpower a lot of negatives.

Our work still suggests that the corporate profit backdrop and the earnings revisions data are still quite supportive of the U.S. equity market, which has been and remains one of the key underpinnings of our longstanding constructive view. Notwithstanding the beginning of the Fed tapering and the apparent less dovish stance by Chairman Powell, I still view the overall liquidity backdrop and interest rates as historically accommodative. It remains to be seen how far the U.S. central bank will go in this normalizing and tightening cycle, but we are of the view that it will likely be less than growing hawkishness among forecasters and traders. Importantly, the critical drivers for equity prices are likely going to remain in place based on our analysis.

So, let’s look at a few of the bricks in the Wall of Worry and what may end up being a quite different outcome than what the mainstream is beginning to move towards:

• Omicron Variant – I have never claimed to have any expertise on this topic and leave the more insightful comments to the experts or to my colleagues Tom Lee and Tireless Ken, who clearly spend much more time on the ongoing pandemic. With this being said, however, when I broadly look at the bigger picture data, it seems that there is a decent probability that this new “Moronic” (an anagram of the proper COVID variant name) could very well be highly transmissible, but also less severe than prior variants. In effect, it could become the dominant strain that is less virulent, and this could actually be quite bullish. It is too early to know for sure and there may be an increase in tactical volatility and some sloppy price action, but as of now we are leaning towards a medium-term neutral outcome at worst.
• Inflation – there is anecdotal evidence that is suggesting that the rate of change in inflation may be nearing its peak and could begin to subside. It is our view that the stagflation and hyperinflation camps will end up being disappointed. If this is case, then the upward pressure on interest rates and the need for more Fed than less will be alleviated, which would also be favorable for equities.

Hence, there is a lot to keep an eye on and the environment will be quite fluid over the next month or so. Because of this, we have become marginally less bullish and continue to use our key indicators to look for what the next big opportunity will likely be. Yet, we are maintaining our longstanding constructive view on the S&P 500.

Continue to stay the course.

Sector Overview

Our new updated sector recommendations are shown below.